Stocks play a prominent role in our financial and economic lives. For individuals, they provide a key instrument for holding personal wealth as well as a way to diversify, spreading and reducing the risks that we face. Importantly, diversifiable risks are risks that are more likely to be taken. By providing individuals with a way to transfer risk, stocks provide a type of insurance enhancing our ability to take risk.¹

For companies, they are one of several ways to obtain financing. Beyond that, though, stocks and stock markets are one of the central links between the financial world and the real economy. Stock prices are fundamental to the functioning of a market-based economy. They tell us the value of the companies that issued the stocks and, like all other prices, they allocate scarce investment resources. The firms deemed most valuable in the marketplace for stocks are the ones that will be able to obtain financing for growth. When resources flow to their most valued uses, the economy operates more efficiently.

Mention of the stock market provokes an emotional reaction in many people. They see it as a place where fortunes are easily made or lost, and they recoil at its unfathomable booms and busts. During one infamous week in October 1929, the New York Stock Exchange lost over 25 percent of its value—an event that marked the beginning of the Great Depression. In October 1987, prices fell nearly 30 percent in one week, including a record decline of 20 percent in a single day. Crashes of this magnitude have become part of the stock market's folklore, creating the popular impression that stocks are very risky.

In the 1990s, stock prices increased nearly fivefold and Americans forgot about the "black Octobers." By the end of the decade, many people had come to see stocks as almost a sure thing; you could not afford not to own them. In 1998, nearly half of all U.S. households owned some stock, either directly or indirectly through mutual funds and managed retirement accounts.

When the market's inexorable rise finally ended, the ensuing decline seemed more like a slowly deflating balloon than a crash. From January 2000 to the week following the terrorist attacks of September 11, 2001, the stock prices of the United States' biggest companies, as measured by the Dow Jones Industrial Average, fell more than 30 percent. While many stocks recovered much of their loss fairly quickly, a large number did not. During the same period, the Nasdaq Composite index fell 70 percent, from 5,000 to 1,500; by summer 2004, it still remained below 2,000. Since the Nasdaq tracks smaller, newer, more technologically oriented companies, many observers dubbed this episode the "Internet bubble."

Contrary to popular mythology, stock prices tend to rise steadily and slowly, collapsing only on those rare occasions when normal market mechanisms are out of alignment. For most people the experience of losing or gaining wealth suddenly is more memorable than the experience of making it gradually. By being preoccupied with the potential short-term losses associated with crashes, we lose sight of the gains we could realize if we took a longer-term view. The goal of this chapter is to try to make sense of the stock market—to show what fluctuations in stock value mean for individuals and for the economy as a whole and look at a critical connection between the financial system and the real economy. We will also explain how it is that things sometimes go awry, resulting in bubbles and crashes. First, however, we need to define the basics: what stocks are, how they originated, and how they are valued.

¹This point was central to our discussions of risk in Chapter 5. Our ability to diversify risk either through the explicit purchase of insurance or through investment strategies means that we do risky things that we otherwise would not do.